It's also the difference between the company being "profitable"
and losing money.

What is this accounting?

The capitalization of editorial costs.

Demand Media doesn't expense the cost of paying its army of
freelance writers when it pays them. Instead, it capitalizes the
costs and spreads the expenses over five years. This makes
Demand Media's bottom line look vastly better than it would look
if Demand Media did what just about every other publisher does,
which is expense editorial costs when they are incurred.

To take a simple example, let's say a particularly productive
Demand Media writer earns $100,000 a year. (Bear with
us...) Instead of taking the writer's compensation as a
$100,000 expense in the year in which the writer is paid, Demand
Media expenses only $20,000. Then it expenses another $20,000 in
each year for the next four years. This has a marvelous
impact on the bottom line.

If Demand Media earned, say, $25,000 this year on the writer's
content this year--and if the company expensed the writer's costs
as incurred--its financial statements would look ghastly:

REVENUE: $25,000COSTS:
$100,000LOSS:-
$75,000

So that's why Demand Media spreads the cost over five years:

REVENUE: $25,000COSTS:
$20,000PROFIT:$5,000

Voila! "Profits."

(Don't you wish YOU could do that? Think about how much
different your personal financial situation would be if you could
do your household expenses that way.)

Now, Demand Media argues--reasonably--that the writer's content
may have value for several years. And, therefore, it continues to
argue, it is okay to recognize the cost of producing the content
over the years that it has value instead of immediately.

Importantly, this is a theoretically reasonable
argument. It attempts to "match" costs with
value, which is what many accounting choices do. It's the
way companies account for things like buildings and factories,
for example. And no one complains about that accounting.

But here are the problems with this accounting choice:

It's unusual and aggressive. Other publishers
don't account for editorial costs this way. (Yes, movie studios
do, but Demand Media isn't a movie studio. It's a web-based
content company. And we now have 15 years of precedent that
web-based content companies expense editorial costs as
incurred).

It makes the company "profitable" when it's actually
burning cash, so it is obviously a choice made to
spruce up the financial statements.

It leads to an instant argument/interrogation about how
long a writer's content will ACTUALLY be valuable (and
Demand Media hasn't even been around for five years, so
confidently saying "five years" begs more questions, especially
given how dependent the company is on Google for traffic and
monetization. What happens if Google changes its algorithm to
punish content companies like Demand Media?)

It is an EASY knock against a company that is
controversial anyway

For these reasons, Demand Media should just drop this accounting
immediately.

And because none of Demand Media's well-compensated advisors seem
to have had the balls to deliver this message, we'll just go
ahead and explain why.

One reason Demand Media is accounting for its content costs this
way is presumably because Demand Media's IPO advisors--Goldman,
Morgan Stanley, etc.--have informed the company that it will get
a better price for its stock if it is "profitable." And
that may be true. But it's still a shortsighted decision.

If Demand Media presses on with this accounting treatment, here's
what's going to happen:

Every shortseller and skeptic about Demand Media is going to hold
forth about this issue every time the company comes up. Every
time Demand Media speaks at an investment conference or holds any
company conference calls, this issue is going to come up. Every
time a journalist writes or talks about Demand Media, this issue
is going to come up. Every time the SEC looks at Demand Media's
financial statements, this issue is going to come up.

It's going to get to the point where every time any investor or
pundit thinks about Demand Media, the first thing that he or she
will think about is, "Ah, yes, Demand Media, the controversial
company with the bogus accounting that makes it look profitable
when it actually isn't."

And although the stock may go up for a while, if there's ever ANY
problem with the business, the "bogus accounting" story will take
over, and shortsellers will move in for the kill.

Demand Media has enough revenue and momentum now that it should
be able to go public even while still losing money. If it
can't--if its underwriters and management can't convince
investors that the model works even using conservative
accounting--then it should just postpone the IPO until it can.

This is especially true because using aggressive accounting
will hurt the company's stock price. Expensing
content costs over five years is not conservative accounting.
It's aggressive accounting. And many investors just
avoid companies that use aggressive accounting, thus leading to
less demand for the stock.

So here's our (free!) advice to Demand Media:

Just drop the aggressive accounting. It may get you public,
but you'll never hear the end of it. It's a shortsighted
decision. And the issue is not going to go away.